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Tuesday, September 09, 2008

Guest Post: Life Insurance Basics

Thank you to my Guest Poster, an employee of Prudential who kindly wrote up a post on the basics of life insurance. I am always indebted to my guest posters. Once more I will take the opportunity to stress the importance of life insurance. Post follows:

There are two types of life insurance – permanent and term. Permanent, as its name implies, provides coverage until you die, as long as you don’t lapse the policy. Term offers coverage for a specified time period. Permanent insurance generally has a cash value that belongs to you even if you lapse the policy, while term provides pure insurance coverage with (usually) no cash value.

A few quick words about permanent insurance. Types of this insurance are Whole Life, Universal Life, and Variable Universal Life. These are basically complicated investment vehicles in addition to providing life insurance. Investment return accumulates tax free until cash value is withdrawn. Most people are better off keeping their insurance and investment needs separate, since permanent insurance doesn’t offer the most competitive investment returns. Certain very high net worth individuals or couples who have insurance needs may benefit from these policies for estate planning purposes. If this is you, you and your financial advisor know who you are.

This discussion will focus on term, which, thanks to competition within the industry, has become quite economical. I’m not going to show sample rates because they vary by age, sex, whether or not you smoke, and your health, but several hundred dollars a year of outlay can buy several hundred thousand dollars of coverage, or much much more.

The type of term you can buy today is generally what’s known as level term. Level term lets you buy a fixed amount of coverage for a period, such as 10, 15, or 20 years, paying the same premium each year. The price is calculated to be level even though the cost of insuring you goes up each year (after all, you’re getting older and you might be getting sicker). The flexibility to buy term insurance for periods as short as 5 years or up to 30 years, depending on your personal needs, is one of the great things about level term.

As I said, there is a great deal of competitiveness in the industry and there is not a lot of price difference among the cheapest 10 companies, so don’t feel you have to shop for the absolute lowest rate. You can buy through an independent agent, which means that he/she is not representing any one company and can search for the policy that’s best for you. I don’t recommend buying life from the same company that sells you homeowners’ or car insurance, though it might be convenient. Many times a property insurer will offer a couple of life products just for this reason, but they are not life specialists and therefore don’t have the most competitive rates.

Your agent should also consider the claims paying ability of the company you are choosing. Ratings from A.M. Best and Standard & Poor’s are available at sites like insure.com. In addition to the big names in the insurance business (MetLife, Northwestern Mutual, AIG, ING), here are some companies which may not be household names that are very competitively priced: Banner Life, West Coast Life, Genworth.

How much term life insurance do you need? The rule of thumb is 10 times income. For example, if your income is $100,000, you need $1 million in coverage. Consider your family size and tuition costs. There is such a thing as mortgage insurance, which is not worth buying as a separate coverage. Make sure your main policy is enough to cover paying off your mortgage. Even a stay at home parent should have life insurance, because of childcare and other household help that would be needed in the event of a claim.

Not surprisingly, your health will determine how much you pay. Companies offer super low rates to people who are in very good health. Depending on the amount of insurance you buy, you will be underwritten based on your health. (Very small policies aren’t underwritten to a great degree). There can be blood tests and a medical or paramedical exam, and a health history and usually a family history will be taken. If you think you have health issues, discuss with the agent, since some companies underwrite more or less leniently and a knowledgeable agent can take this into account when recommending a policy.

Here are some health issues that you might not realize are big considerations. Have you been diagnosed with depression? Do you have high cholesterol? Even if these problems are controlled with medication, they will count against you, although you may still be able to buy an affordable policy, especially at younger ages. Obesity will also count. These are in addition to obvious sicknesses such as heart problems, history of cancer, etc.

Therefore, it’s good to buy a policy when you’re still young and healthy.

By the way, it’s not a good idea to every lie on an application, even if you think you can get away with it. Besides the fact that it’s totally wrong, if you do ch”v have a claim, especially in the first 2 years (a legal period known as the “contestable period”), your application will be scrutinized. There is a difference between fraud (actually trying to defraud an insurer) and misrepresentation (knowingly or accidentally fudging the facts). These are actually complicated legal terms, but either way, if you lie you will either get caught before the policy is issued or if there is a claim, it may face legal challenges.

Insurance is one of the few things we buy hoping never to use it, but there are unfortunate events, and claims happen every day. If you have a claim, your insurance company will probably offer to put the proceeds in an interest bearing account for you. This is worth considering, even though common sense says that the company is doing this so that they can continue to make money. People don’t usually think straight after experiencing something traumatic like the loss of a spouse, and you may be tempted to use the money unwisely. Tie the money up in an interest bearing account (if you don’t want to leave it with the insurer, you can shop around for a good rate, but something tells me this is not what someone wants to do when they’ve just had a loss), leaving an amount available for living expenses, and at some point get financial advice on how best to use the proceeds to meet your future obligations.

Let’s say you live to the end of the level term period – now what? If you have timed your policy to expire when your dependents no longer need the death benefit – good for you, that is what you should have done. But what if, for example, you had a baby unexpectedly later in life? When the term period runs out, you will probably still be eligible for coverage, but your rates will skyrocket, and go up each year thereafter. If you are still healthy and young enough you may be able to buy a new policy on the open market. If not – let’s say you have health problems that make you uninsurable – you may find it worthwhile to keep the original term policy even at the super high rates. Some policies allow you to convert to a permanent insurance policy from a term policy without further underwriting. It’s more expensive than term, but this may be the way to go if your health does not allow you to buy a new policy.

There is a fairly new type of insurance out there called Return of Premium Term (ROP Term). This pays you back all your premiums if you live to the end of the level period. It’s more expensive than regular term insurance. It appeals to people who feel that they have to get something for their money no matter what. It’s a psychological need some people have. If this is you, you might consider it.

24 comments:

Mike S. said...

The rule-of-thumb you offer strikes me as somewhat irresponsible. There are people for whom 10xincome is way under-insured, and other for whom it is way over-insured. People really have to consider there individual circumstances. How much insurance you need will depend on what needs your family has, what addition expenses, if any, will be incurred in your absense, what other income and assets will be available to your family, and how you expect these things to change over the term of the policy. it would be nice to offer a good rule-of-thumb, but, unfortunately, there is no substitute for thought and planning.

Hesh said...

As an actuary, I can attest for the accuracy of this presentation -yasher koach to the mystery man/woman at Pru. One addition -- I would consider 30-year term, as that will generally cover through your key earning years (which is when you need the insurance).

JS said...

Very good and informative post.

Can you provide any guidance on how long of a term should be sought? You seem to indicate one should pick a term until your dependants no longer need the money.

Also, any more guidance on how much coverage to get? Let's say one only wants to cover tuition until all kids are out of college, do you just add up all that money and get coverage for that? Do you factor inflation? Should one view insurance as an opportunity to pay off all future outlays if c"v something bad happens? For example, both spouses should have enough coverage to completely pay off mortgage, tuition, and all basic expenses? Should insurance be used to provide a life of relative luxury if c"v something happens?

aml said...

Nice posting. Thanks. Just one question though- the 10x your salary rule doesn't seem quite right. The way we've done it is we've figure out how much it will cost to raise one child, given cost-of-living, tuition (day school and university, and the cost of a year or two in Israel), and the cost of a wedding for each. These are obviously rough numbers but the idea is that if something should happen to one of us, the children are financially covered That's how we do it. If you have a person who earls $40k a year and has 8 (young) kids, it doesn't seem to me that $400k would be enough to cover the cost for all 8.
Just a thought :).

Commenter Abbi said...

. "It appeals to people who feel that they have to get something for their money no matter what. It’s a psychological need some people have. If this is you, you might consider it."

Isn't this a financial need as well?
This is a pretty funny line considering how most people around here are obsessed with frugality.

Anonymous said...

abbi

Not if you're overpaying for the benefit - which is how it's priced.

Premiums are higher, plus the premiums that you receive are returned without interest.

SephardiLady said...

Hopefully my guest poster will come answer questions. The highlights are mine, btw.

Regarding abbi's comment--Life insurance products often have different products attached, and it is confusing to wade through the advantages and disadvantages. IMO the purpose of life insurance is to have the assurance of being covered and a residual or cash value isn't that important, although there are reasons to "get something" which is why some people will take a whole life policy despite the cost. Normally whole life policies aren't a great investment, although there are exceptions and estate planning reasons. But like the guest poster said. . . .those people know who they are and this post is not a primer in fancy estate planning.

Commenter Abbi said...

Full disclosure: I'm the daughter of a life insurance agent who always felt whole life generally provided more comprehensive coverage, not just for fancy rich pple. But every family has different needs.

I think it's the difference between renting and buying a home. There are financial pros and cons to both.

mystery guest poster said...

js

You raise some good questions. First of all, I do think that you would want to time the end of the term period for when the benefit is no longer needed.

Second, I love your question about whether one might want to improve one's lifestyle by buying a large amount of coverage in the unfortunate event of a claim. I didn't mention that there is such a thing as financial underwriting also - the insurance company wants to know not only are you insurable health wise, but does the amount of coverage you're buying make sense given your current financial station. The concept of "moral hazard" applies in that if one is going to become substantially better off in the event of a loved one's death, a claim might be more likely (use your imagination!)

Even with financial underwriting, many people can still buy plenty of coverage, enough to up their lifestyles substantially. It would be unseemly (from my point of view) to see a widow living it up because of her husband's death. However, most people tend to underinsure and to underestimate their future needs. I think even if one planned for luxury, within limits, the money would be needed for more mundane things. That's my personal opinion.

Ezzie said...

Has anyone done a substantive analysis of ROPs to see what the "return" is relative to the extra layout? I would think that that is an extremely important factor.

ROPs seemingly make more sense for someone like myself (25) or other young couples who are likely paying less and have a greater likelihood of making it through the term. Moreover, if it's only a ten-year term, it's even more true.

No?

mystery guest poster said...

Ezzie - good point again - which is why the companies don't sell 10 year term. The benefit gets phased in later in the term period. You only get the full benefit after at least 20 years. And of course, if you lapse for nonpayment or any other reason before the end of the term, you've paid extra for nothing.

mystery guest poster said...

Of course, I meant they don't sell the ROP product on the 10 year basis. I think the shortest one available is 15 year ROP term.

Anonymous said...

Another way to "create" a ROP policy is as follows. Let's say you want $1M in coverage with ROP for 10 years. And let's say that 10 year term for $1M is $480/yr. All you do is take $9,600 and place it into a 10-year CD yielding 5% paying quarterly (or whatever) and use that interest to pay for your insurance. At the end of the 10-year term you still have your whole $9,600 (i.e. your "premium" is returned to you).

Mark

Ezzie said...

mgp - I believe a friend mentioned a 10-year ROP to me last week (we're currently about to get life insurance; I should note that my father sells life insurance as well).

tdr said...

re: "upping" your lifestyle through substantial amounts of life insurance.

My sister's philosophy was that she and her husband bought enough life insurance so that neither would have to work in the event of the other's demise. So they have enough life insurance to cover both incomes. They figured it would be stressful enough to be a single parent/widow(er) without having to work full-time in addition.

And they could afford it.

I thought this was a good idea.

Ariella said...

According to a life insurance agent I spoke with there really is no one-size-fits-all rule of thumb for how much coverage one needs to buy. Each individual has to look at his/her own scenario. I wonder if the 10X was arrived at by figuring the whole amount could be invested to yield 10% a year, so that the income would remain unchanged. But the fact is that very few investments can guarantee a 10% yearly return. But as one should buy life insurance when young to lock in the lowest possible rates, they would hope that their income would rise for them as they advance in their careers and gain work experience. Let's say a 25 year-old earns $40k a year. On a solid career track with advancement (not to mention inflation and cost-of-living increases), this person would hope to have at least doubled his/her income by age 35. So if a $400,000 policy was purchased 10 years prior, would you say to buy an additional policy later?

another jewish accountant said...

my financial advisor recommended that we "ladder" our term policies rather than taking out a more expensive whole life policy. what we did was, in our early twenties, took out a 20 year term policy with very low rates. about 5 years later we took out another 20 year policy, thereby doubling our coverage for the next 15 years, and extending the term for 5 more years, we are actually about to do that again this year, increasing the coverage to 3x what we originally had. that original policy will expire in 10 years, and we will probably do this again at least for the next 10 to 15 years. that way our coverage will be highest in the highest "need" years (when our kids are in highschool/college/weddings, etc.) as the policies begin to lapse, our need will hopefully decrease as well, once our house is paid off, and the kids are finished their school years.

at 23 years old, we couldnt really afford more insurance than those first policies, and this way we have been able to take advantage of the low rates for our age groups.

just something to consider, especially since your insurance needs change as time goes on, you buy a house, have kids, etc.

Lion of Zion said...

ANONYMOUS POSTER:

is there any incentive to an agent to sell ROP as opposed to term?

also, how does one decide what is a better company, particularly in these turbulent times. i'm specifically looking at prudential. since you're anonymous anyway, what do you think about this company?

Lion of Zion said...

ANONYMOUS POSTER:

what's the best way to shop around?

(thanks for the great post)

Anonymous said...

I'm the author of the guest post. Wow, questions 6 months later.

ROP - I don't think there's much difference, if any, in the agent compensation structure compared to regular level premium term. Of course, the ROP premium, which is the basis for compensation, is higher.

I think SelectQuote might be a good way to shop. From what I understand, you give them your info and they give you a single quote. Their reps are salaried, not commissioned, and they follow a very specific process.

I don't know how I would go about finding an independent broker, other than good word of mouth recommendations.

My feelings on Pru - I think all companies are being hit by the high cost of capital and low investment values. The rating agencies are being extremely tough (maybe to make up for their laxness in the past). We are told that our position is sound. Policyholders are more protected than investors, so I wouldn't be worried about buying a policy. And as for investing, the share price is at such a low, it's probably a great bargain for someone.

Anonymous said...

One more thing about ROP is that regulatory changes are going to result in increased prices by all companies by 2010. If people are thinking about buying this product, do it sooner rather than later.

Lion of Zion said...

GUEST POSTER:

i know the ROP premium is higher (double actually in my situation). the agent is "pushing" (i don't mean that in a very negative way) the ROP, so that's why i was curious if he gets anything out of it.

i am going to try to get an actuary acquaintance to run the numbers and see in what situation it would or would not be worth it. i don't have a head for math, but for some reason it doesn't seem worth it. if i am going to spend twice as much on my premiums i think i'd prefer regular term but getting a larger policy

i like that ladder approach described a few comments back. the only problem is that i think it will be harder (financially) to suddenly take on an extra permium ten years from now.

thanks for responding.
you should write another post. even if only person gets a policy because of it, it's worth it.

Lion of Zion said...

GUEST POSTER:

with term policies, how important is it to have a policy with better convertibility options?

and is there any sense in the optional riders (e.g., payment waver, accident insurance)? they were very expensive and the only one that made some sense was the payment waiver, but it was still way too much money.

tesyaa said...

Riders are the simpler question. They are very expensive and a big profit source to the company. They help make up for the razor thin margins on the base policy. ADB - accidental death benefit - is a joke. It's been around forever. If you can figure out why someone would need a double benefit when they die in an accident, rather than from an illness, let me know.

Conversion is a very powerful right to the consumer. Basically, your price is set by your age and underwriting status. Once you have been underwritten, the company has no further information about your health. If you become sick, you may be uninsurable when your term policiy reaches its end. Yes, you can probably continue the policy at YRT (yearly renewable term) rates, but these are astronomical. If you know you have become uninsurable, the right to convert to permanent insurance, without further underwriting, is a very powerful option. Companies know it can be used against them, and conversion costs are reflected in the pricing model.

So it's a tradeoff. If you are willing to go with a company that has cheap term rates but may limit your conversion options, that's a gamble you might find worth taking. I think companies, which are all pressured for the economic reasons I mentioned before, are going to raise rates and / or reduce benefits. They have to. They may limit the length of the conversion period or stipulate that you can only convert to a specific permanent policy, which might be expensive compared to their other offerings.

I myself might not pay extra for a great conversion option, as long as there was *some* conversion option offered. You can't cover all risks, but you can at least have some contingency plan available.